Established in 2008, this blog is an independent, common sense, look at challenges and opportunities in sports and financial investing, with occasional diversions as my mood takes me. I am not a tipster, nor is this a Profit and Loss report either. They are boring.

Friday, 12 February 2016

Very occasionally, hidden among a pile of detritus, there's an interesting article on the Yahoo! Finance page. I'm sure I have written on this topic before, but apparently it wasn't on this blog, (or at least I can't find it), so it was probably published elsewhere, but it starts with the known phenomenon of pro golfers being more likely to save par than to make a birdie, when putting from the same spot. Being, at least nominally, a Finance related page, the author Cass R Sunstein extends the example to the stock market:

Can professional golf help explain what is now happening with the stock market? I think that it can, because it offers a clue about an important source of this month’s market volatility: human psychology.

The best golfers make par on most holes. They also have plenty of chances to make a welcome birdie (one under par) or to avoid a dreaded bogey (one over par). To do either, they have to sink a putt.

A stroke is a stroke, so you might think that whether a pro makes a putt can’t possibly depend on whether the result would be making a birdie or avoiding a bogey. But you’d be wrong.A study of over 1.6 million putts shows that professional golfers are significantly more likely to succeed in sinking a par putt than a birdie putt of equal distance and difficulty. Remarkable but true: If the average top golfer putted as well for birdie as he puts for par, he would make an additional $1.2 million a year.

Why do golfers do so much better when they are putting for par? The best explanation, coming from behavioural science, is that most people are “loss averse,” meaning that they dislike losses a lot more than they like equivalent gains.

A loss from the status quo is very painful, and so people will do a lot to avoid it. A gain is good, but it isn’t nearly as good as a loss is bad. Like the rest of us, professional golfers are affected by what John Maynard Keynes called “animal spirits”: the feelings of the primitive creatures who lie within us. Hating the prospect of losses, golfers focus intensely on avoiding those bogeys, and often succeed.

Which brings us to the stock market. Of course it’s true that the recent volatility, and the sharp declines, have a lot to do with real-world events, including slower growth in China and rapidly falling oil prices. But the fundamentals remain pretty solid, and the ultimate effects of such factors are at least partly a product of psychology.

Investors know that stocks go up and down, but losses loom much larger than gains, and when the market gets especially volatile it’s tempting to sell. Even if your portfolio ends up the same on March 15 as it was on February 15, the interim losses tempt many people to get out. And if it’s a terrible month, a lot of people will want to avoid more bogeys -- and scale back their holdings.

A closely related phenomenon is called “probability neglect.” When an outcome stirs strong emotions, people tend to neglect the likelihood that it will occur. If the prospect of a bad result gets the heart racing -- a plane crash, a terrible disease, a loss of 30 percent of your portfolio -- most people will take strong steps to avoid it. They will pay too little attention to a comforting thought, which is that worst-case scenarios usually don’t come to fruition.

Loss aversion and probability neglect operate at the individual level, but much of our behaviour is a product of social interactions, which multiply their effects. Even when the fundamentals are strong, making significant market declines unlikely, investors are affected by the actions of other investors. Like a bank run, a decline in stock prices creates its own momentum.

In the most extreme cases, what happens, and what we are now witnessing, is an “informational cascade,” in which investors attend to the signals given by the behaviour of other investors, even if their own information suggests that the other investors are wrong.

Informational cascades help fuel sell-offs. If many investors are perceived to be selling, there is a snowball effect, as the “should sell” signal gets louder, not because people have reliable information that selling really makes sense but simply because of the behaviour of others.

The good news is that in ordinary circumstances, investor cascades are halted. The smart money is aware of everything I have said here, and if the fundamentals really are strong, savvy investors start buying. They aren’t loss averse, they don’t neglect probability, and they spot opportunities when they see them. If there are enough of them, they can stop and eventually reverse dramatic movements driven by animal spirits.

History tells us that in the long-run, equity markets will do just fine. In the short-run, however, the prospect of bogeys can create a lot of havoc, especially if a lot of people decide that they want to get out of the game.

About Me

I have had a life-long interest in sports and after studying Pure Mathematics with Statistics at secondary school, have been fascinated by odds and probability.
The first system I came up with was a simple one - back the favourite and double up after a loss until a winner. Simple enough in theory, and I told my Dad about it. Not being a betting man himself, he ran it by some of his colleagues, and came home to tell me that it wouldn’t work because a long losing run would mean that the bank would be empty. Then there was always the possibility that the winner would be returned at odds-on, meaning that the total returns would not match the outlay. Not what a ten year old wants to hear! Only slightly daunted, I then went on a search for the Holy Grail, the secret to riches that I knew was out there somewhere. Finally in 2004 I stumbled across an article about Betting Exchanges and four years on I am able to make a steady profit. I am at that age where I can start thinking about retirement and anything I make from trading sports will bring that day forward.